Will Congress Avoid A $1T Budget Penalty?

Exactly how Congress will navigate the fiscal minefield it laid for itself between now and the end of the year is a mystery even to lawmakers. But that does not stop anyone in Washington from trying to influence the process or play it for political advantage.

Last August, lawmakers passed the Budget Control Act, which required the government to reduce the federal deficit by $1.2 trillion over a decade. Without a new congressional agreement, the government will face an across-the-board budget cut of about $1 trillion on Jan. 2, 2013.

Then, the entire federal government—from NASA to the FAA—will be in line for steep reductions. The Pentagon alone stands to lose $500 billion over 10 years, $53 billion of which will come due in January in a fashion that could cost the government move money in the long run, and force the nation into a double-dip recession.

But obtaining a deal will require lawmakers to reach an agreement on issues that most Congresses never want to touch. They will have to alter government health care entitlements for the elderly at a time when the country's population is aging and increase taxes when a large swath of Congress has signed pledges not to do so. And even issues that typically pass without notice—such as the bill to reauthorize the Export-Import Bank's lending authority—nearly failed.

Here is your guide to the positions and possibilities in play over the next six months, as the deadline for averting that penalty, known as sequestration, draws closer.

THE PUNT FORMATION Lawmakers interested in reaching a “grand bargain” to reduce the federal deficit—one that combines reductions in entitlement spending as well as tax increases—are quietly negotiating an agreement that could be attached to a spending bill that must pass before the fiscal year ends Sept. 30. That deal would not solve the deficit problem but would establish a framework for discussions on deficit reduction and other tax issues early next year, after the November elections have passed.

Sen. Lamar Alexander (R-Tenn.) says Republicans are all looking at the best way to resolve a number of tax issues. In terms of avoiding sequestration, Alexander says it is important to lay the foundation for whoever is elected president.

“We need to create a fertile ground here in the Senate, in the House, to help him succeed,” says Alexander, who is talking with both parties behind the scenes to facilitate such an agreement. “Tax reform is at the top of the list of most Republican senators. Many of us feel that means broadening the base, closing the loopholes, and it could include more revenues. But for me, only if we have a plan to reduce mandatory spending.”

Despite the urgency from some Republicans, who want to buy time for a Mitt Romney administration, some lawmakers on the other side of the aisle such as Sen. John Kerry (D-Mass.) say an interim agreement is possible but unlikely. “I'm not going to say, 'No, under any circumstances,' but the likelihood is low,” Kerry says.

THE LAME DUCK If anything, Kerry and others fall into the lame-duck camp, saying that once lawmakers know who controls the White House, the Senate and the House, they will be free to act. But if Romney wins the presidency, Republicans would want to wait for him to take office before acting.

The other complicating factor in this scenario is the schedule, which will be anything but lame. In addition to dealing with sequestration during the last two months of the year, Congress will likely have to pass spending bills to keep the government running, deal with the expiration of the Bush tax cuts, other tax-extension issues and a major health care discussion.

With those constraints in mind, Sen. Carl Levin (D-Mich.) has talked often about reaching some kind of minimal framework before the elections that would show investors and the public that Republicans are willing to close tax loopholes and Democrats are willing to address entitlement spending. Republicans including Sens. Lindsey Graham (S.C.) and John McCain (Ariz.) say they are willing to close some loopholes and are talking about a potential deal.

SOUND THE ALARM Rep. Buck McKeon (R-Calif.), chairman of the House Armed Services Committee, has been on a year-long campaign to illustrate how searingly painful sequestration would be to the defense industry. McKeon is focused so intensely on the defense budget it can be hard for him to shift to other topics. Asked recently about the need for congressional oversight for the president's reported involvement with kill lists, secret wars in Yemen and a possible cyberwar on Iran, McKeon sidestepped these issues, bringing the conversation back to the budget.

Last week, he wrote a letter to the Office of Management and Budget formally requesting director Jeffrey Zients to testify before his committee on the impact of sequestration. On the Senate side, McCain and others are trying to pass a bill that requires the administration to spell out the impacts on the federal government.

Within industry, the Aerospace Industries Association (AIA) and the National Association of Manufacturers have promoted studies showing that sequestration could cause the loss of more than one million jobs. Steven Fuller, a professor at George Mason University, who conducted the study cited by AIA, points out that steep job losses due to sequestration and other economic factors could begin within the first weeks of the new year. By mid-July, Fuller plans to issue a follow-up study examining the impact of the budget cuts to other federal agencies, which he says could double the effect of job losses and drive the economy into recession.

Impacts are already being felt in the information technology sector. And lower-tier suppliers with smaller cash reserves and services contractors reliant on operation and maintenance dollars could feel the hit first, says Todd Harrison of the Center for Strategic and Budgetary Assessments.

Still, the uncertainty created by sequestration is making it difficult for contractors to select where cutbacks will occur. Consequently, Lockheed Martin Chairman Robert Stevens warned recently that layoff notices for some or all of its employees could be sent out just because of the company's legal obligations in September and October, preceding the election. “For us, the consequences of sequestration are real, and they're nearer-term than some discussions that are underway today that suggest in the lame-duck session of Congress, after the November election, sequestration can be undertaken then,” Stevens says.

DON'T OVERSELL IT Though industry officials say the anticipated fallout from sequestration is very, very real, some worry that companies could face a publicity backlash by being too dramatic about the potential effects. The Worker Adjustment and Retraining Notification (WARN) Act requires only that large companies notify employees of potential layoffs. And major prime contractors, whose businesses are supported by funding over multiple years, may not immediately feel the impacts of sequestration.

Gordon Adams, an American University professor of foreign policy, notes in an op-ed article in The Hill that just one-third of the one million jobs lost due to the blocking of defense funds would come from the defense industry. The other two-thirds would flow from that. Adams adds that even the size of sequestration is not as bad as some are making it out to be and that it will not be as rigid as it appears. The Pentagon is also likely to have some ability to transfer money between accounts to manage the spending cuts.

PREPARING FOR THE POSSIBILITY While virtually no one agrees that sequestration is a good way to budget, camps in both political parties are prepared to let sequestration take effect, either as a means to cutting the budget, to motivate action or because of inertia. Already, though, industry is preparing for the possibility. Early in the year, companies were optimistic about a lame-duck compromise. But when the first-quarter earnings reports were issued, “it was clear that was no longer the case,” says industry analyst Jim McAleese of McAleese and Associates. “All of the companies went into a cash-holding situation.”

For now, he says, stocks tend to be priced based on the expectation that Congress will eventually agree to a deficit-reduction deal that hands down an additional $20 billion annual decrease in the planned base defense budget over the decade.

THE VIEW FROM THE TOP Amid all of the bluster about what should be done, lawmakers generally acknowledge that Senate Democrats and House Republicans will bring this to the brink. To prevent the country from falling off the so-called “fiscal cliff,” few lawmakers are willing to step out on their own political precipices. McKeon listed moderate Republicans and Democrats who lost primary elections because they were attacked by more extreme wings of their parties. “These were solid citizens . . . who tried to work on things,” McKeon said. “It's gotten pretty devastating out there.”

And as the days of the legislative calendar slip by, the Senate Majority Leader Harry Reid (D-Nev.) is still using the threat of sequestration as a hammer to pound away at the need for deficit reduction.

“People focus on the defense [budget], as they should. They should spend a little bit of time worrying about the other $600 billion that also has an effect on other areas of peoples lives,” Reid says when asked about the impact on the defense community. “I don't intend to move on this until something comes along that's better.” c

Effect of Sequestration on Defense Spending

$ billion

$531

Base budget under Continuing Resolution at Fiscal 2012 rates

+26

Energy Department and other related activities (enacted Fiscal 2012)

+85

Unobligated balances from Fiscal 2012 and previous years

+88

Overseas Contingency Operations (OCO) (Fiscal 2013 request)

729

Total defense spending

-141

Military personnel (assumed exempted by president)

-88

OCO (assumed exempted by legislation)

-125

Monies obligated during first quarter of fiscal year (Oct. 10, 2012-Jan. 1, 2013)

374

Total defense pot for reduction by sequester

-15%

Effect of the $55 billion sequester on the $374 billion remaining, including investment accounts

Source: Bipartisan Policy Center

Sequestration Time Line

9/30/12 Appropriations to fund the government for Fiscal 2013

11/3/12 60-day advance notification deadline for layoffs due to the sequester under the WARN Act